Absurd Gold-Stock Levels

Gold stocks suffered a full-blown panic this past week! This exceedingly-rare
magnitude of selloff was triggered by extreme futures shorting intentionally
executed to force a flash crash in gold. After gold's major multi-year support
failed in this Machiavellian onslaught, gold stocks plummeted. The levels of
fear were so epic that this entire sector was slammed much deeper into fundamentally-absurd
price territory.

The gold-mining industry is minuscule compared to the broader markets, a realm
only a tiny fraction of investors follow. Although these are mostly hardcore
contrarians who fight the crowd, gold stocks' small constituency still leaves
them exceptionally susceptible to herd emotions. Fewer traders make for less
liquidity and more volatility, tending to amplify prevailing greed and fear
and therefore prices to outsized extremes.

The flagship gold-stock index is the NYSE Arca Gold BUGS Index, which is better
known by its symbol HUI. And the leading gold-stock ETF, the Market Vectors
Gold Miners ETF trading as GDX, tracks
the HUI perfectly. Both bear painful witness to the panic that just unfolded
in this already-battered sector. The HUI last peaked in late April, and its
subsequent relentless decline was sowing the seeds for this panic.

As of last Thursday July 16th, the HUI had fallen for 8 consecutive trading
days for a cumulative loss of 10.5%. Such a long streak of down days is very
rare, so it stoked serious worries. And every one of those losses hammered
the HUI farther under early November 2014's brutal 11.3-year secular low. So
the psychological pressure on gold-stock investors and speculators to capitulate
was utterly crushing.

And then the actual panic started. A panic is a 20%+ drop in a stock index in
less than 2 weeks. They usually happen at the end of long bear markets
near devastatingly-low prices when sentiment is already overpoweringly bearish.
Gold stocks are certainly not the only sector subject to the runaway bearish
psychology necessary to fuel panic selling. Back in late 2008, we witnessed
a once-in-century stock
panic.

The benchmark S&P 500 plummeted 25.9% in exactly 2 weeks leading into
early October that year, wiping out a quarter of Americans' stock-market
wealth! And gold stocks have suffered a handful of panic-grade selloffs since
early 2000. So while these are exceedingly-rare events, they do happen from
time to time. But since so vanishingly few selloffs snowball into full-blown
panics, they are impossible to predict.

While I explained this past week's events leading into this gold-stock panic
in great detail in our latest Zeal
Speculator, here's the nutshell version. Last Friday, China's central bank
finally admitted for the first time since April 2009 that its official gold
reserves had grown. But the reported number was only 1658 metric tons, far
below the 3500ish tonnes analysts had expected. This really disappointed traders.

While most firmly believe China's reported gold-reserves level remains a total
fiction, they still sold gold futures to a 1.0% loss. That wasn't much in the
grand scheme, but it still pushed gold below its deep major early-November-2014
bottom to a new 5.3-year low. That left gold very vulnerable technically, decimating
already-terrible gold-stock psychology. The HUI plunged 5.2% to extreme new
12.2-year lows of its own.

The gold price had been blasted to such deep lows not by a glut of physical
supply, but by record
gold-futures shorting by American speculators. Since futures shorts must
soon be covered, lows driven by them are artificial and transitory.
Excessive gold-futures shorting always soon reverses into proportional guaranteed
near-future buying. So major lows sparked by extreme short selling are
actually super-bullish!

But most traders succumb to the popular fear major lows spawn, as they've
failed to spend enough time studying market history to inoculate themselves
from emotional extremes. The short sellers decided to take advantage of this Sunday
night and press their luck. So they carefully chose the most-illiquid time
in the global gold markets to unleash an astonishing barrage of gold-futures
short sales to try and run the stops.

Since the CME closed gold-futures pits earlier this month, there is no more
normal US trading day. The electronic gold-futures sessions start at 6:00pm
NYT Sunday through Friday and end at 5:15pm the following day. The short sellers
chose to strike at 9:30pm Sunday night, when American traders were not watching
the markets, Japanese traders were on a public holiday, and just before Chinese
markets opened.

In just over one minute, they dumped an astounding $2.7b worth of gold
futures in notional terms. At the Friday gold close of $1134, this would work
out to nearly 24k gold-futures contracts! This blizzard of selling was so extreme
that it forced two 20-second trading halts within just over a minute.
The sole purpose of such an epic blitz of shorting was to artificially force
gold below stop-loss levels on long contracts.

Happening at such an illiquid time, gold plunged about $48 to $1086 in that
super-brief span. This gold flash crash was incredibly artificial and
manipulative! When something similar happened in the US stock markets in May
2010, traders rightfully viewed it as a transitory anomaly. But sentiment in
gold was so extremely bearish that it was instead wrongly considered to be
righteous fundamental selling.

Even though gold recovered nearly half those fake losses within 15 minutes,
the psychological damage was done. Gold ended up falling 3.2% on Monday to
$1098, a new 5.3-year low. And the gold-stock investors and speculators totally
panicked, fleeing the gold stocks so aggressively the HUI plummeted by 12.0% that
day! This was its worst down day since December 2008 in the dark heart of that
stock panic.

So through 10 consecutive daily losses, the HUI had collapsed a full-on panic-grade
25.3%! Naturally this total capitulation caused tremendous pain for those long
gold stocks, leading to mass stoppings. And the HUI had fallen to 113, a mind-boggling 12.7-year
low! Such levels were truly fundamentally absurd, wildly unjustified.
They were completely the product of super-extreme fear-dominated herd psychology.

This first chart looks at the HUI gold-stock index and gold over the past
dozen years or so. Gold stocks have totally disconnected from the metal
which drives their profits, and hence ultimately stock prices. This extraordinary
capitulation extreme offers once-in-a-lifetime opportunities to greatly multiply
wealth for those hardened contrarians tough enough to buy low while everyone
else flees in sheer terror.

Everyone hates gold stocks today, convinced they are doomed to spiral
lower into oblivion. But that worldview is clouded by irrational emotion. Gold
stocks were recently one of if not the best performing sector in all the markets.
Between November 2000 and September 2011, the HUI powered 1664% higher in a
life-changing secular bull! While gold-stock investors multiplied their wealth by
18x, the S&P 500 lost 14%.

Gold-stock prices have always been a leveraged play on the price of gold,
since the profits for mining gold amplify its price movements. If a miner can
produce gold for $1000, and it's trading at $1100, that miner earns $100 per
ounce. But if a mere 10% gold rally boosted the metal to $1210, that miners'
costs are still $1000. So its profits more than double to $210! This
incredible profits leverage makes gold stocks so alluring.

Throughout the entire stock markets, price levels are ultimately determined
by underlying corporate profitability. So as gold prices rise, gold stocks
soar. They more than quadrupled as measured by the HUI leading into
the late 2000s, and again into the early 2010s. This is perfectly-normal behavior
in this sector, earning the brave contrarians who fought the crowd in the early
2000s hundreds of billions of dollars.

Gold stock prices temporarily decoupled from gold to the downside in late
2008's stock panic, with the HUI falling to 5.3-year lows. Even though gold
was trading in the low $700s, the gold stocks were down at prices last seen
when gold was in the $350s in the summer of 2003! But as I argued
at the time to much ridicule, it made zero sense for gold stocks to trade as
if gold was half its prevailing price levels.

And indeed gold stocks soon rallied sharply out of that late-2008 fundamentally-absurd
low, with the HUI more than quadrupling over the next several years.
And the gains in the smaller gold miners with superior fundamentals dwarfed
those of the majors dominating the HUI and GDX. But by August 2011 as I warned
then, gold
was getting overbought. So it was due for a major correction and consolidation.

Naturally gold stocks were hit hard in this righteous gold selloff, since
their high profits leverage works to the downside too. Relatively modest declines
in gold prices can lead to sharp drops in earnings. By the time late 2012 rolled
around, this sector was recovering nicely with the newest major upleg underway.
And then something wildly unprecedented happened, the Fed launched its third
quantitative-easing campaign.

Unlike QE1 and QE2, QE3 was totally open-ended with no predetermined
size or end date. Fed officials used this ambiguity to their advantage to actively
manipulate stock-trader psychology. Whenever the US stock markets started to
retreat, Fed officials rushed to jawbone about how they were ready to ramp
QE3 to arrest any material stock-market selloff. Traders soon realized the
Fed was effectively backstopping stock markets!

So in early 2013 capital fled alternative investments led by gold to migrate
into the perceived-riskless US stock markets. Gold plummeted on epically-extreme
gold-ETF selling in 2013's second quarter, leading to gold's worst quarterly
loss in 93 years! This hundred-year storm destroyed gold-stock sentiment,
so this entire sector radically decoupled to the downside. It has struggled
ever since, faring far worse than gold.

That radical anomaly finally culminated in this week's capitulation extreme,
with the HUI plunging to these 12.7-year lows. That compares to gold at just
a 5.3-year low. This chart shows how ridiculous this disconnect has become.
The last time the HUI traded at this week's levels was way back in October
2002. At that time, gold was trading in the $310s! Gold-mining profitability
was radically lower back then.

Even at this week's dismal gold lows, this metal was still a whopping 3.5x
higher than its late-2002 levels. So it is supremely irrational for the
HUI to trade at such fundamentally-absurd levels. "Absurd" is the right word
too, defined as "extremely unreasonable, incongruous, or inappropriate".
There is truly absolutely no way, no conceivable scenario, in which today's
gold-stock prices could be considered justified.

Their levels can be viewed from the gold side too. The last time gold traded
at this week's levels back in March 2010, the HUI was over 400. Today
collective gold-stock prices are just over a quarter of those levels at
that same gold price. This is incredibly illogical, and doesn't reflect
the profitability of mining gold at prevailing prices. After studying gold-stock
valuations for many years, I understand them far better than most.

Yes, there are gold-mining companies out there with all-in sustaining costs
well over $1100 per ounce. Yes, there are gold miners today that are heavily
indebted with little hope to dig out at these low prevailing gold prices. Yes,
some of these high-cost debt-financed gold miners have gone bankrupt, with
more to come. There is no doubt some gold-mining companies are in serious trouble
at today's gold prices.

But painting all the gold miners with the same brush is silly, as ridiculous
as claiming Apple and Netflix are in the same fundamental boat because they
are both technology stocks. Apple is trading near 15.7x earnings these days,
while Netflix has a terrifying 247.4x trailing P/E ratio! Gold stocks are no
more homogenous than any other sector, with wild variations on their outlooks
at these shorting-fueled gold lows.

There are plenty of great gold miners out there so amazingly profitable even
today that they are trading at dirt-cheap single-digit P/E ratios! There
are plenty with all-in sustaining costs far below current gold levels,
that could survive if not thrive even if gold plunged by another quarter or
more. There are some gold miners now trading at total market capitalizations less
than their cash in the bank, which is epically cheap!

But since extreme popular fear leaves the baby to be thrown out with the bath
water, gold-stock investors and speculators have irrationally fled the great
companies. And as this emotional extreme inevitably fades and mean reverts
back to normal psychology, the best gold miners' stocks will soar far faster
than the broader HUI. Contrarians who deploy capital now with blood in the
streets stand to really multiply their fortunes.

Since gold-stock profits and hence stock prices are ultimately determined
by the gold price, my favorite way to consider prevailing gold-stock levels
is by comparing them with gold. This is done through the venerable HUI/Gold
Ratio, which divides the daily HUI close by the daily gold close. Charted over
time, this construct shows whether gold stocks are cheap or expensive. And
today they've never been cheaper!

This week, the HGR fell to a staggering all-time record low of 0.103x!
Nothing anywhere remotely near these extreme levels of gold-stock undervaluation
relative to gold has ever been witnessed before. Not even during 2008's once-in-a-century
stock panic, the greatest fear superstorm we'll see in our lifetimes. Today's
incredibly-low HGR levels are wildly unprecedented, and absolutely not sustainable
for long.

In the 5 years before that incredible general-stock panic, the HUI/Gold
Ratio meandered in a tight range between 0.46x support and 0.56x resistance.
Its secular average was 0.511x, the HUI index level trading at about half prevailing
gold prices. The 2008-stock-panic capitulation broke the resolve of many long-time
gold-stock investors, so they panicked and sold low never to return.
Thus the post-panic HGR was lower.

2009 to 2012 were the last quasi-normal years in the financial markets before
the Fed started grossly distorting everything with its radically-unprecedented
QE3 debt monetizations. During that time, the HGR averaged 0.346x. Just to
return to those comparatively-modest pre-QE3 gold-stock price levels, the HUI
would have to soar nearly 3.4x higher! The upside potential from today's
extreme lows is utterly massive.

The great wealth-killing mistake traders always make during stock panics by
succumbing to the extreme fear is assuming those price levels are fundamentally
righteous and the new status quo. But nothing could be farther from the truth,
as financial markets are forever cyclical. Extreme fear soon burns itself
out, and the great sentiment pendulum starts slowly swinging back the other
way towards the greed side.

Extreme absolute 12.7-year HUI lows and all-time HUI/Gold Ratio lows aren't
sustainable. Gold stocks can't and won't continue decoupling from gold
prices forever. This gold-stock panic is as bullish for gold stocks today
as the last one was in late 2008. Again after that the HUI more than quadrupled over
the next several years, and the smaller gold miners with superior fundamentals
greatly amplified those sector gains.

The 9-year-old trend of gold-stock prices losing ground relative to the metal
which drives their profitability and hence ultimately stock prices is way overdue
to dramatically reverse. Extreme emotion can only drag prices away from fundamentally-righteous
levels for so long. Gold stocks will eventually reflect their underlying profitability,
with the best of breed skyrocketing as gold-futures
short covering gets underway.

Capital is going to return to chase gold stocks at these fundamentally-absurd
price levels. Even if the existing gold-stock investors hammered by this panic
are too discouraged to return, new investors will take their place. There's
a whole new generation of millennial investors just learning about market cycles,
and they are eager to buy low and sell high. Being so young, they have long-term
time horizons as well.

Many traders are concerned about not buying until the absolute bottom. But
that day won't become fully apparent until weeks later when gold stocks
have already surged by a third or more. Buying low requires deploying capital
when everyone thinks it's crazy, when the act of clicking that buy button leaves
you feeling nauseous. Buying extreme lows, and holding if prices slide lower
still, is very challenging psychologically.

But this necessary mental sacrifice is well worth it considering the potential
rewards, coming gold-stock gains from 4x to well over 10x as this left-for-dead
sector mean reverts far higher. Another leg down in gold stocks is exceedingly
unlikely since panics mark absolute lows, so potentially forgoing 900%
upside because you're worried about another 20% downside is foolish. Gold stocks
have never been cheaper.

And that's what we've long specialized in at Zeal. While our positions suffered
mass stoppings too in this latest irrational panic, we've been aggressively
buying the extreme lows this week. This strategy of fighting popular fear isn't
easy, but it's netted amazing gains for our subscribers. Since 2001, all 700
stock trades recommended in our newsletters have averaged annualized realized
gains of +21.3%! The majority over the years have been gold and silver stocks.

Since gold stocks have never been cheaper relative to gold, there've never
been better opportunities to multiply your wealth in this hated sector. We've
long published acclaimed weekly and monthly newsletters
for contrarian speculators and investors. They draw on our decades of exceptional
market experience, knowledge, and wisdom to explain what's going on in the
markets, why, and how to trade them with specific stocks. Subscribe
today, see which gold stocks we're buying at panic lows, and save 33%!

The bottom line is gold stocks are trading at fundamentally-absurd price levels
today. They plummeted into an ultra-rare full-blown panic after futures speculators'
record shorting went nuclear in an attempt to run stops. Gold stocks are trading
at levels last seen when gold was in the low $300s, and have never been cheaper
relative to the price of the metal that drives their profits. This extreme
anomaly isn't sustainable.

The leading gold-stock index more than quadrupled after the last panic in
this sector, with far bigger gains seen in the smaller fundamentally-superior
gold miners. Extreme fear always soon burns itself out, and sentiment always
subsequently recovers leading to serious gold-stock buying. With markets forever
cyclical, there's no doubt gold stocks will soon mean revert far higher to
fundamentally-righteous price levels.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to
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